Sunday, January 4, 2015

It also explains why the fiscal multiplier is low.


In comments here on the problem with Quantitative Easing, Auburn Parks said:

The real problem with QE is that it doesn't add any Govt liabilities for the private sector to hold as wealth.

I quoted that back to him and replied:

So you are saying that the real problem with the economy is that there is not enough financial wealth for the private sector to hold? You would have to convince me.

Geerussell said:

This is a great excuse to roll out this old chart from way back.

He linked to this graph:

Graph #1: Dollars of Private Debt for each Dollar of Federal Debt (black line, right scale)
The graph shows a measure of private debt (red), a measure of Federal debt (green), their sum (blue), and their ratio (black). The black line shows that, for every dollar of Federal debt, there was from four to six dollars of private debt (reading the right-side scale). Then, in the mid-1990s it went to eight dollars of private debt, and in the 2000s it went briefly to nine dollars of private debt for every dollar of Federal debt.

Geerussell writes,

There are two ways to reduce the burden of debt. Reduce [private] debt, or increase the equity on which it rests. I'd say there's a pressing need to pursue both avenues.

Geerussell's point is that if the high level of private debt relative to Federal debt is a problem, then we can solve that problem either by reducing private debt or by increasing Federal debt. Or both.

I can't argue with that arithmetic. But I look at things differently. If the high level of private debt relative to Federal debt is a problem, I want to understand why the ratio is so high. I ask: Why is private debt so high? and Why is Federal debt so low?

Funny, isn't it? Federal debt is NOT low. It is only low relative to private debt, because private debt is so massively big. Anyway, apparently both Geerussell and Austin Parks would be happy to see the Federal debt increase. I'd rather see private debt decline.

Why is private debt so high? If we don't answer that question, private debt could stay high despite a significant increase in Federal debt. I mean, if we grow the Federal debt on purpose to make the black line fall, private debt might increase faster also, so that the black line does not fall. If the black line does not fall, the ratio remains high.


Here is an updated version of the previous graph:

Graph #2: An Updated, Longer-Term version of the Black Line on Graph #1
Graph #2 goes back two decades further into the past than #1. It also uses improved measures of public and private debt. So the high values achieved on Graph #1 are only about half as high on #2: four instead of eight in 2001, 4½ instead of 9 in 2008. But the two graphs show the same pattern.

Economic growth in the 1950s and '60s was generally good, supported by strong and persistent growth of debt -- as you can see from the strong uptrend on the graph during those decades. There was a little hesitation in 1967 and again during the 1970 recession, as the ratio reached  2.5-to-1 and 3-to-1. Then, from the 1974 recession to the early 1990s the ratio ran flat or trended slightly down. Economic performance was not impressive in those years, because debt and financial costs had already reached a high level.

Eventually the ratio fell a bit, and by the mid-1990s started climbing again. And the economy was good again, while the ratio climbed. But climbing pushes the ratio higher; financial costs take more of a bite out of profits and aggregate demand; and the economy slows again.

Finally, the burden of debt broke the economy, we had the crisis and "great recession", and the ratio started falling. It is lower now than it was at the onset of the 1990s boom, and that is promising. But at $2.5 dollars of private debt per dollar of gross Federal debt, the ratio is still high today.

It was increase in the private debt ratio that made vigorous growth possible; we see this 1950-1970, we see it 1994-2000, and we could see it again soon.

Increases in private debt make the economy vigorous. But the increases push the ratio up, making further increase less likely. And when the ratio runs high, the economy runs into trouble. We need the ratio low in order to attain a sustained period of economic vigor.


Is increased government participation the solution to the problem? Well... Was there a fall in government participation that caused the problem?

No. Government participation did not fall:

Graph #3: Debt in Billions -- Total Private Debt (red) and Gross Federal Debt (blue)
The high ratio could have been caused by the fall of government participation, or by the rise of private participation. But government participation did not fall. It grew. So the high ratio was not caused by the fall of government participation. So it must have been caused by the rise of private participation.

We use credit for growth; therein lies the problem.



I worried above, that

if we grow the Federal debt on purpose to make the black line fall, private debt might increase faster also, so that the black line does not fall. If the black line does not fall, the problem remains.

That is in fact what we see between 1971 and 1991 on Graph #1. The black line wanders along a horizontal trend path. This means that private debt was increasing at about the same rate as the Federal debt.

You can see it on Graph #2 also: the red line runs roughly flat from 1970 to 1990. So if it is true that the Federal government increased spending and deficits in an attempt to restore economic vigor to our flagging economy, then it must be true that private debt increased more rapidly also -- at about the same rate as the Federal increase.

Graph #4 shows the Gross Federal Debt as given in FRED's FYGFD series. That's the blue line. The red line is an exponential trend line generated by Excel for the years 1945 to 1974:

Graph #4: Gross Federal Debt (blue) and the Golden Age Trend (red)
The red line is an exponential curve based on the Federal debt of the Golden Age. Think of it as showing what the Federal debt would have been if we did not grow the Federal debt on purpose to restore economic vigor.

Think of the gap between the red and blue lines as extra debt accumulated in the process of trying to drive the private/public debt ratio down. Trillions and trillions and trillions of dollars.

Did all that extra Federal debt push down the ratio on Graphs #1 and #2? No, it did not. We know that private debt and Federal debt grew at about the same rate for near 20 years, from 1970 to 1990 or so. Twenty years of unimpressive economic growth. The boost to Federal spending created an inadequate boost for the economy because private debt remained high.

If your plan is to fix the economy by expanding government spending, well, your plan has already been tried. It didn't work.

Why didn't it work? To be blunt, it didn't work because we didn't have a Depression in those years. A Depression would have wiped out a lot of private debt while the government spending was pumping money into the economy. That didn't happen.

Instead, the private sector took every new dollar of government money and diced it up into many more dollars of private lending and debt. Instead of falling, private debt increased.


Why is private debt so high? Because we have many policies that encourage the use of credit, and no policy that encourages repayment of debt.

Increasing Federal spending and Federal deficits will not restore vigor unless policies are put in place to limit the expansion of private debt -- for example, by tax incentives for accelerated repayment.


Related posts:

Debt Relatives: The Cousins

FRED: Federal spending as a % of GDP (blue) and Federal deficits as a % of Federal spending (red)

More cowbell


10 comments:

Auburn Parks said...

Really nice work Art-

There is just one problem with your desire to decrease private debt while not simultaneously increasing the private sector's net income via Govt deficits:

https://research.stlouisfed.org/fred2/graph/?graph_id=214254

Reductions in the growth of private debt have been associated with every recession for the last 50 years. This is one of the most powerful correlations in macroeconomics.

Unfortunately, there is no way to reduce private debt without encouraging a recession. Luckily, recessions are the easiest of all economic problems to fix. You simply increase the private sector's income through increased Govt spending or reduced Govt taxes.

One more thing, the decrease in the private debt contribution to GDP multiplier we've seen since the 70's, coincides perfectly with the rise of income inequality.

Poor people have all the debt
Debt is a financial asset of the wealthy

The Arthurian said...

"Reductions in the growth of private debt have been associated with every recession for the last 50 years."

Sure, because we rely on credit for everything. Policy should instead assure that there is enough money in the economy to sustain the existing level of economic activity... And policy should be designed so that we use credit for growth, not for everything. (This means (for example) that policies promoting inequality should be turned around, so that we can maintain our standard of living without resorting to more and more credit-use.)

The way things are now, we use credit not only for growth but for everything. So the moment that rising interest rates, or panic, or what-have-you causes people to cut back a tad on their borrowing, we get a recession. What has to change is our underlying assumption that it is okay to use credit for everything.

//

A definition, for the record: The difference between money and credit is that money does not have to be paid back and doesn't demand interest payments.

//

"... there is no way to reduce private debt without encouraging a recession."

The assumption that there is no way is the biggest part of the problem.

Auburn Parks said...

"Sure, because we rely on credit for everything. Policy should instead assure that there is enough money in the economy to sustain the existing level of economic activity"

"money" in the domestic economy can only come from 3 sources:

Govt deficits
Bank loans
trade surpluses

I feel like you continue to overlook this fundamental part of the monetary system in your analysis.

Paying off bank loans reduces the amount of money in the economy, which is why doing so is associated with recessions.

So if we want to reduce private debt (and I completely agree that we should prioritize this policy), the only way to hold the supply of money constant is some combination of the other 2 sources of domestic money increases.

"The difference between money and credit is that money does not have to be paid back and doesn't demand interest payments."

Thats not a useful way to describe the situation. If I take out a $300K mortgage to buy your house, the bank creates the bank deposits for me that I then trade to you. In your framework, its "credit" to me because I must pay back my loan, but those bank deposits are "money" to you since you now have them and dont have anything to pay back.

The only source of financial asset the private sector can hold that was not created with an offsetting private sector liability is the Govt's deficit.

"... there is no way to reduce private debt without encouraging a recession."

The assumption that there is no way is the biggest part of the problem"

History is clear on this matter. Reducing private debt causes recessions in a vacuum. but we can and should compensate for this by adding money from 1 of the other 2 sources. That this doesnt happen is 100% a result of misunderstanding the nature of Govt finances.

It seems like to me you are saying we can have non-recessionary private sector reductions without offsetting fiscal policy. If we ignore the trade balance (USA is not going to a net exporter any time soon, thankfully), this is impossible.

The Arthurian said...

"In your framework, its "credit" to me because I must pay back my loan, but those bank deposits are "money" to you since you now have them and dont have anything to pay back."

Yes, that is exactly right.

Thank you!

geerussell said...

Art said...

If the high level of private debt relative to Federal debt is a problem, I want to understand why the ratio is so high. I ask: Why is private debt so high? and Why is Federal debt so low?

Funny, isn't it? Federal debt is NOT low. It is only low relative to private debt, because private debt is so massively big.


To gain insight into the stocks of debt, let's look at the flows that feed them. Here again, a wonderful excuse to blow the dust off of old favorite charts. First, sectoral balances.

Each line is a flow of net spending. The red line is government. The black line is all non-government. What I want to highlight here wrt private debt is the green line, where the flow of domestic private net spending is broken out. Look at what is happening to the green line when the red line moves towards surplus.

As the government moves into surplus the domestic private sector moves into deficit! This is where government participation is determinant because if the government is in surplus, the math says something has to give. If the foreign sector isn't going to accommodate the surplus then it comes out of the hide of the private sector. Which brings me to the next chart, flow of domestic private spending overlaid with leverage. Here the timing is highlighted. The green line goes negative, leverage shoots up. Twice.

Flows of spending feed stocks of debt. Lastly, a big ol' mess of an overly-ambitious chart (if it looks familiar, that's because it's not the first time I've trotted out any of these) trying to tie together the stocks and flows to tell a story.

Auburn Parks said...

Art-

if I didnt take out a loan, where would the money have come from that I used to buy your house?

Income? Then where would the payer of my income have gotten their money from to pay me?

And so on until we regress back to the original source of the money aka credit expansion (ignoring the other 2 sources).

So in effect, credit = money in our example, so its not helpful to say that there isnt enough money when you are rightfully worrying about there being too much credit.

Because an equivalent statement would be there isnt enough credit but there is too much money (again, ignoring the Govt and foreign sources).

It doesnt make any sense, because the two things are equivalent.

The Arthurian said...

"It doesnt make any sense, because the two things are equivalent."

Auburn, it may well be that the quantity of money and the quantity of credit are equal, on your definitions. But it is beyond me how you can say that a dollar free and clear is "equivalent" to a dollar I have to repay with interest.

The other day you were comparing M2 and T-bills, saying if the savings in M2 is money then the savings in a T bill must also be money. Okay...

That's where the money is, that isn't in the economy being used for transactions. It is in savings ((or in China)). That's why the money being used for transactions is so much less than the quantity of existing debt. That's how I see it.

I have to say it my way, because I use the FRED numbers on spending-money and accumulated debt. But we think much alike.

The Arthurian said...

Geerussell,
I looked at the relation of the three data series for the "flows" side of your third link.

I think you did a lot of work to show that what goes into one pocket comes out of another.

geerussell said...

I think you did a lot of work to show that what goes into one pocket comes out of another.

Ha! Come to think of it, that kind of captures the idea of stock-flow consistency :)

The Arthurian said...

And without all that painful accounting!